19.07.23 Review

Demand Overheating: Central Bank plans to cool the economy with a rate hike to prevent inflation from accelerating ahead of elections

According to experts from the Central Bank in their latest ‘What the Trends Say’ report, the Russian economy has entered a phase of overheating, with the growth rate of demand lagging behind that of supply. The budgetary stimulus implemented since the beginning of the year was supplemented in the second quarter by intensive growth in consumer demand. However, the report also highlights that the structural transformation of the economy to focus on domestic demand still lies ahead. The growth of production is facing constraints from the labour market, production capacity, and technology. A significant challenge in the near future could be the risk of disruption to restructured cross-border supply chains, including technological chains, due to secondary sanctions. The overheating of demand poses a risk of inflation exceeding its target and the tightening of monetary policy needs to be implemented before inflation accelerates, according to the Central Bank. The Kremlin perceives a surge in inflation during the pre-election period as a critical risk, thus the Central Bank will continue to adopt a conservative approach. The key rate will be raised at the meeting on July 21, and the only remaining question is the extent of this increase. The rate hike is expected to cool down demand and impact the pace of economic recovery while leaving the military sector unaffected.

The Russian economy is experiencing noticeable growth, but high demand is creating inflationary pressure as it outpaces the growth rate of supply of goods and services, according to experts from the Central Bank in their July issue of their 'What the Trends Say’ report.' In other words, it follows the trajectory that Re: Russia predicted a month ago: the economy, which has recently experienced a downturn, is now entering an overheating phase under the influence of significant budgetary stimuli combined with active credit growth.

Examining the Russian economic situation with a wider lens, the experts from the Central Bank note that its structural transformation, driven by the war and sanctions, has so far affected the geography of exports and imports to a greater extent than their physical volume. While import substitution can be observed in certain sectors and product niches, this cannot be said about the economy as a whole. As previously mentioned, export revenues are currently at the level seen in 2019, while total imports have exceeded figures from 2019 by 25% — all while Russian GDP has grown by approximately 3% since the beginning of 2019. Growth is observed in the majority of industries, although some sectors (such as the automotive industry or air transportation) are far from recovery. At the same time, there has been explosive growth in military-related sectors. In their breakdown of industrial growth, the Central Bank experts demonstrate the contribution of 'heavy' sectors to the investment sector.

Output of manufacturing industry groups, 2017-2023, 100 = January 2016

The significant stimulus to the economy from the budget, which has been in effect since the beginning of the year, has been further supplemented in the second quarter by the growth of consumer demand, supported by both real wage growth and an expansion of lending. However, according to the experts from the Central Bank, there are still significant constraints to production from the labour market, production capacity, and technology. In other words, further growth in the consumer sector of industry is being limited by labour shortages and the fact that production is almost at maximum capacity, amid the disruption of several previously existing production chains (for example, in the automotive industry). Additionally, the experts note that there are delays in the implementation of complex projects as well as increased costs, by which they are likely referring to projects aimed at import substitution of components and assembled products for domestic production.

Salary dynamics, 2019-2023, 100 = January 2019

Generally speaking, the report's authors come to the conclusion that 'the main structural shifts in the sector of the economy oriented towards domestic demand still lie ahead,' despite the fact that demand is already at a high level. Additionally, the Central Bank experts anticipate the ‘technological challenges’ to intensify over time, referring to the absence of satisfactory analogues for Western equipment integrated into production chains. Another significant challenge in the near future will be the risk of disruption to restructured cross-border supply chains, including technological chains, due to secondary sanctions.

All of this creates a risk of high inflation stemming from structural constraints to the growth of domestic production. Another factor that is poised to contribute to price increases is the sharp weakening of the ruble. Thus far, according to the Central Bank experts, the effect of the exchange rate on prices has been mitigated by accumulated stockpiles of inventory, but this will inevitably intensify in the future. Largely due to the fluctuation to the exchange rate, citizens' expectations for inflation rose from 10.2% to 11.1% annually in June, according to a survey conducted by 'inFOM'.

According to the Central Bank's assessment, the actual price growth in June, seasonally adjusted, accelerated (0.52% compared to 0.39% in May) and exceeded the level corresponding to an annual inflation rate of 4%. However, according to the Central Bank's baseline scenario, inflation in 2023 should be between 4.5% to 6.5% in order to return to the target rate of 4% in 2024. The current inflation rate is still within the range for this scenario. The Central Bank’’s July macroeconomic survey raised the inflation forecast for 2023 to 5.7% (+0.2 percentage points compared to the June survey) and to 4.3% for 2024 (+0.3 percentage points). However, the authors of the ‘What the Trends Say’ report emphasise the fact that a 'tightening of monetary policy’ (i.e. rate hikes) should occur before inflation accelerates; otherwise, significantly more fiscal tightening would be required (the authors italicise 'before' for emphasis in their report).

The Kremlin sees a surge in inflation during the pre-election period as a critical risk, and are thus in favour of the conservative approach adopted by the Central Bank. As a result, it is almost inevitable that the key rate will be raised from the current 7.5% during the upcoming meeting on July 21, marking the first increase since September 2022. A question remains about how high this will be raised. The rate hike is expected to cool down demand and will impact the pace of economic recovery while leaving the military sector unaffected. The July analysis of macroeconomic trends by the Center for Macroeconomic Analysis and Short-Term Forecasting (CMASF), which has close ties to the Russian government, also warns that the 'weakening of the ruble (rising import prices) and the increase in the Central Bank's key rate could reverse the emerging growth trend.' In other words, the impact on the pace of recovery will be twofold: from monetary policy and from imports, on which the economy is currently relying.